Emerging market debt hits investment grade

Emerging market bonds reached investment grade for the first time ever last week on the January 8 upgrade of Turkey’s government bonds by Moody’s. The average credit rating for the 39 countries that make up the benchmark JPMorgan Embi Global Diversified Index moved up one grade from junk to investment grade, according to Moody’s ratings. Standard & Poor’s still rates the index junk on average, but I think Standard & Poor’s is on track to follow Moody’s.

The improved credit ratings for emerging market bonds—government issues from Turkey, Brazil, Peru, and other developing economies—has collapsed the spread with government bonds from developed economies. Spreads on the JP Morgan Embi Diversified Index, which tracks dollar-denominated bonds issued by emerging economy governments, now trades at a relatively small 2.73 percentage point spread to U.S. Treasury bonds. Emerging bonds paid 5.93 percentage points more than Treasuries back in October 2008 when investors feared that the entire global financial system could seize up.

Money moving out of developed country bonds and into emerging market issues is likely to keep spreads shrinking. Large institutional investors such as Pimco and Baring Asset Management have been moving assets into an asset class that returned 26% in 2009.

Not every investor is convinced, however.

Some analysts are calling for a sell-off in 2010. At least one big investor, in fact, seems to have made a huge contrarian vote in yesterday’s (January 13) auction of new U.S. Treasury 10-year notes. Direct bids, that is those not made through the primary dealers who buy most Treasuries, rose to 17% of sales in the $21 billion offer. That was a huge surge from the recent average of 7.4% of sales going to direct bidders in recent auctions. Speculation is that one big investor who didn’t want to alert Wall Street dealers to the move, was responsible of the increase in direct bids.

That buyer would seem to be betting on at least a temporary correction in the long term trend.